Technical indicators can be a traders’ best friend. They are like searchlights showing the path and deciphering complex situations where prices move in unexpected ways. But they can also confuse and obscure the picture.
That’s why we decided to go over their building blocks and show how technical indicators should be used correctly.
So let’s start at the top – what are they? Indicators are mathematical formulas that use price variations from the past of instruments like EURUSD, Gold, Ethereum, etc. Using them they can generate a visualization of the past but different from the one seen on the chart itself.
The goal of this new picture is to give more information than the chart and identify points for buying and/or selling.
Note: No indicator is 100% correct and there will never be one that achieves perfection.
There are three categories of indicators:
- Lagging indicators – their best use is for finding the direction of trends. One example are moving averages. They are all visualized with a line on the chart itself, splitting it in two. Where the current price is at that time determines the action a trader should take.
- Leading indicators – specialized in identifying good points for opening trades. The two most popular among the leading indicators are MACD and the (Slow) Stochastic. The name of this type contains their main goal – to show the change in momentum and the current direction for the trend. The Elliott Wave Principle is also forward-looking but it is not an indicator due to the absence of mathematical formulas.
- Confirming indicators – this group consists of indicators that are actually made of data that is indirectly related to the price history of the respective instrument. Prime examples are the volume indicator (and all its variations) and the volatility index VIX.
A good mix of indicators is considered to have a bit of everything – one lagging, one leading and one confirming. But that would be about it, no more than three indicators are ever necessary.
The more important challenge is to find the right ones for the specific instrument you’re trading. RSI could be good for EURUSD, but bad for USDJPY in the particular moment. The Moving Averages might not be too informative for traders that buy and sell Bitcoin.
After you do find a good indicator that matches your desired instrument, there are a couple of other things to be careful about. One of them is that indicators can give different signals when you look at instruments on different time-frames. The trick here is to find those points where the signs on all (or most) time-frames are pointing in the same direction.
Indicators like these are part of the arsenal of the trader who doesn’t want to be influenced by their emotions. It requires discipline to trust them.
But here’s the thing – they can be misread or just used in an incorrect way. Trading based on technical indicators is not and never will be an exact science. That’s why you should rely on several indicators tailored towards your preferred instruments and trading style. This won’t guarantee that all your trades will make a profit but it’s better than throwing dice like most traders are actually doing.